Understanding and Controlling Your Finances

Buying a Home

by Marshall Brain
Home ownership is an important part of the "American Dream,"
and is a significant way for a person or family to express its
individuality and independence. For many people home ownership
marks an "arrival" in the same way that graduation or
a first child does.

The purchase of a home is probably also the most complicated financial
transaction in which a person participates during a normal lifetime.
The first time you undertake a home purchase, the complexity of
the transaction can be particularly frustrating because there
are a number of unknown rules and procedures that you are generally
forced to learn through "the school of hard knocks."
We know a number of people who simply gave up the first time they
tried to buy a house because too many unexpected things happened
during the process. They ended up waiting perhaps six months or
a year and then starting over again. It can be that difficult.

The purpose of this article is to help you to understand the home
buying process so that you can approach it from a position of
understanding rather than confusion. In this article you will
learn about the different types of homes available, the financial
limits that banks apply to you when you try to get a home mortgage
(and which therefore control the type or size of house you can
afford), the extra and often unexpected costs that you will incur
during the closing process, and some of the hazards to watch for
as you go through the transaction. Once you have finished this
article you will prepared to go forth and do battle with the banks,
Realtors, lawyers, and loan officers who stand between you and
the home of your dreams.

The Basics

Imagine that you would like to buy a new television. In America
just about anyone can drive down to the local discount store,
pick out a TV, and purchase it with a credit card in about 10
minutes. The process is easy, well understood, and accepted by
everyone.

Now imagine that you want to buy a new car. This transaction is
a bit more complicated but still relatively straightforward. If
you have the cash for a car in the bank then you can:

Drive to the dealer

Pick out the car

Haggle on the price

Sign a contract

Write a check

Call your insurance agent to bind coverage

You can drive the car off the lot the same day. If you have to
get a loan for the car then it might take a day or two to contact
a bank and arrange for the loan (provided that your credit history
is good), but you can still drive the car away with relative ease.

Now imagine that you want to buy a house. In general the process
is going to take at a very minimum a month, and more typically
between three and six months. There is also a fairly good probability
(perhaps 25%, depending on your situation) that, once you find
a home you like and wish to purchase, you will be unable to buy
that particular home and will have to start over again. A typical
question for the first time buyer to ask at this point is, "What
do you mean that I may not be able to buy the house that I pick
out?" As you go through this article you will begin to understand
that there are a number of things that can go wrong if you are
not prepared (and sometimes even if you are ). There are
three fundamental things that complicate the home buying process:

Each home is a large, distinct, immovable, one-of-a-kind object
with a distinct one-of-a-kind seller who happens to live in it.
This fact means that human emotions and personalities play a much
larger role than they do in most other common financial transactions

No normal person has enough cash to buy a home, so you are
forced to go to a bank and ask for a loan whose size may be measured
in the hundreds of thousands of dollars. No bank is going to undertake
a loan of this size lightly.

All homes rest on a piece of land, and with that land is associated
a certain amount of government red tape including the deed for
the property and sizable taxes on the home. The process of transferring
ownership of a home is not nearly as simple as it is for other
objects that we commonly purchase.

Having said all of this, you can expect that any home purchase
will involve at least the following steps, provided that everything
goes smoothly:

Make the decision to purchase a house

Get your financial affairs in order

Decide on the type of house, the location, and the price range
you can afford

Talk to a Realtor and start looking at houses

Find a house that you like

Make an offer on the house

Negotiate a price

Shop for and select a mortgage company

Apply for a mortgage

Wait for approval on the mortgage

Wait for the closing

Attend the closing and sign all the paperwork

Move in to your new home

In the following sections we will discuss each of these steps
so that you can understand each one.

Step 1: Make the decision to purchase a home

The decision to purchase a home is not a small one, and involves
a number of variables. Some of the considerations that you should
keep in mind are listed below:

Are you able to commit to a specific location for a period
of several years? If your job or lifestyle requires you to change
location frequently, then you should not purchase a home. There
are two reasons for this. First, a home is not very liquid. It
can take months or years to sell a home when you need to move.
Second, when you sell your home a Realtor will charge you a 7%
commission. That means that in many locations you will have to
hold the home for several years so it can appreciate in value
or you will lose money when you resell it.

Are you qualified to obtain a mortgage? Step 2 will help you
determine whether you are currently qualified for a mortgage.
If not, you can begin the process of becoming qualified by saving
for the down payment, improving your credit history and paying
down existing debt.

Are you financially, physically and emotionally prepared to
maintain the home? Owning a home is different from living in an
apartment complex. In an apartment complex the grass is mowed,
the buildings are repainted and appliances are fixed by the owner
of the complex. When you own your own home you have to do these
things yourself or pay someone else to do them. If you are not
interested in painting, mowing and fixing, then a house if not
for you (although a town house or condo might be - see Step 3). You
will also have to pay significant property taxes and insurance
premiums once you own a home.

Keep all three of these considerations in mind as you are deciding
whether or not to buy a home. On the other hand, you should also
keep the following advantages in mind:

A house offers you a way to accumulate wealth. When you pay
rent on an apartment, that money buys you nothing but living space.
By spending about the same amount of money each month to pay the
monthly payment on a mortgage, you instead build wealth. If you
have a 15 year mortgage, then after 15 years of payments you have
accumulated an amount of money equal to the value of your house.
In addition, the value of your home will normally appreciate at
some rate, with the minimum rate being equal to inflation. Therefore,
if you buy a home for $100,000 then after 15 years you will have
accumulated $100,000 through your mortgage payments, and in addition
the home will have a value of $156,000. Instead of accumulating
nothing by paying apartment rent for 15 years, you accumulate
$156,000.

A house offers significant tax advantages. You gain two important
tax advantages though home ownership. First, interest paid on
a mortgage is tax deductable. This means that the effective interest
rate on the loan is reduced by your income tax rate. In addition,
when you sell a home you are allowed to roll the money generated
from the sale into a new home without paying any taxes on the
appreciated value (i.e. capital gains) of the home. A home is
the only investment that works in this way under current tax laws.

A fixed rate mortgage stops the "rent increases"
that you would see at an apartment complex. Your monthly payment
will remain the same until the loan is paid off.

The price per square foot for a house is sometimes lower than
the price per square foot for an apartment, depending on the area.

A house lets you express your individuality. When you live
in an apartment you take what you get. You generally cannot repaint
or renovate an apartment. When you own a home you can do whatever
you want.

A house offers privacy. Your home is your castle, so you don't
have to worry about people running overhead or playing their stereos
at 3:00 AM.

As you can see, home ownership has important advantages and disadvantages,
and the decision to purchase a home therefore should not be made
lightly.

Step 2: Get your financial affairs in order

Before most people can purchase a home, they must get a loan.
The most common form of loan used to purchase a home is called
a mortgage. In a mortgage, the borrow pledges to repay
the loan as specified, and the lender is given the right to seize
the property should payments ever be interrupted. A mortgage
deed, issued by the lender and recorded at the county tax
office, contains an accurate description of the property and the
payment terms of the loan.

Because a mortgage is usually for $100,000 or more, banks tend
to be fairly particular about the people to whom they grant a
mortgage. In general a bank will require you to demonstrate five
things before giving a mortgage to you:

You must have cash on hand for a down payment. Generally an
amount equal to 10% of the home's purchase price must be available.
In addition, you need to have enough cash on hand in order to
cover closing costs as well. Closing costs are the fees
you must pay to all of the people and organizations involved in
the purchase of a home.

You must have a job with a reputable employer that pays a
steady annual income.

You must show that the amount you are borrowing will not overburden
you financially. In order to confirm this banks use two standard
test. The first test, which could be called the allowable
monthly housing cost test, ensures that your monthly mortgage
payments will not exceed 28% of your gross annual income. The
second test, which could be called the allowable total monthly
debt payment test, ensures that your total monthly payments
for all debt including your mortgage payments do not exceed 36%.
These ratios are good things because they help people to avoid
overextending themselves. For example, if you bring home $2,000
per month and had to make a $1,500 mortgage payment each month,
it is virtually guaranteed that you would either starve to death
or default on your loan. The first test tries to prevent this from
happening. In the same way, if you have a number of outstanding
loans for cars, boats, furniture, etc. and tried to load another
large loan on top of the pile, then it is also likely that you
would eventually default. Test 2 guards against this problem.

You must have a clean and strong credit history

You must have an acceptable balance sheet and net worth.

It is possible to obtain certain government-backed mortgages that
bend some of these rules. For example, an FHA mortgage (a mortgage
backed by the Federal Housing Authority) will generally lower
the down payment requirement. In general, however, you can expect
any mortgage company or bank to follow these rules fairly closely.

You meet the first requirement by saving money over time. There
is no other way to do it. If you look back at some of the earlier
articles in this series (particularly the article entitled "Incentives"),
you may be able to define home ownership as one the things that
are important in your life, establish it as a financial priority,
and then begin a savings program to accumulate a down payment.

You meet the second requirement by having a steady job with a
predictable income. You will need to be able to get confirmation
of employment from your employer when it is requested by the bank.
You will also have to supply tax returns for three preceding years
to show your income history.

You meet the third requirement by looking at your current financial
situation and figuring out the maximum amount of money you can
borrow based on the test.

You can use the Mortgage Ratio Calculator to help you determine how much money a bank or mortgage company will allow you to borrow. (To run this calculator you will need a web browser that understands JavaScript. The later versions of NetScape, the MS Internet Explorer, etc. all do)

If you find that you are way off base when you look at the ratios,
then you can do two things: 1) you can plan on accumulating a
larger down payment or buying a less expensive home, and 2) you
can reduce existing debt.

You meet the fourth requirement in two ways. You build a clean
credit history by paying your bills on time. You obtain a strong
credit history by obtaining and repaying other loans, like credit
cards, car loans, etc. If you have never obtained and repaid a
loan prior to attempting to get a mortgage, it is likely that
the bank will frown on this fact. It is therefore important to
build a credit history by obtaining and using credit cards, obtaining
and repaying a car loan, etc.

A bank will check your credit history by obtaining a credit report
for you from a credit
reporting company like TRW. You can and
should obtain your own copy of your credit history ahead of time
and make sure that the report you receive is accurate and contains
no errors. If you know that you have a spotty or poor credit history,
you should work to repair the damage. The best way to do this
is to talk with a credit counselor. The
Fannie Mae Foundation
(a private company chartered by Congress) can provide you with
help finding credit counselors and other mortgage information.
Call 1-800-699-HOME for further information and assistance.

You meet the fifth requirement by presenting to the bank a net
worth statement. The bank is primarily interested in your existing
assets (to demonstrate financial strength) and your existing debts.
You can prepare a net worth statement using the net worth calculator
discussed in the article entitled "Understanding your Current Position".

Please Note:

As you are getting your finances in order, you may wish to talk
with your bank or a mortgage company and get their opinion on
your financial health. This will save you the embarrassment and
frustration of applying for a mortgage and being rejected after
spending a significant amount of time finding a home you like.
Many mortgage companies will pre-approve you for a certain
mortgage amount, and going through this process can be very beneficial.
Once you are pre-approved, you will know exactly how much money
you can spend on a new home, and you will also save yourself the
hassle of getting approved once you find a home you like.

Step 3: Decide on the type of house, the location, and the
price range

There are at least six different types of housing you can purchase
in most markets:

A house - A house is a detached single-family dwelling. It
stands by itself on its own piece of land and you own and maintain
both the house and the land. This is what most people think of
when they think of "buying a house," and it is the most
common type of property on which to obtain a mortgage.

A Duplex (tri-plex, etc.) - A duplex is a detached multi-family
dwelling. In a duplex there are two units (in a tri-plex three,
and so on) that share a wall and the same piece of land. You purchase
the entire duplex and the land it sits on in the same way that
you purchase a house. Then you can live in one half and rent the
other. The rental income can go a long way toward paying a mortgage
payment.

A town house - A townhouse is normally part of a row of connected
units. You own the portion of the building you live in and its
land. However, each owner becomes associated with some sort of
collective or management company that maintains the grounds and
the exterior of the buildings much like an apartment complex would.
You pay a monthly fee for this service. The advantage and intent
of this arrangement is that the exterior appearance of all units
is maintained.

A condominium - In a condominium you own an apartment-like
unit but not the land underneath it. A management company owns
the land and the building your condo exists within. You pay a
monthly fee to the management company to maintain the building
and the grounds.

A co-op - In a co-op you purchase shares in a corporation
that owns the building and land. Ownership of these shares gives
you the right to live in an apartment in the building. Because
all owners own shares in the corporation, they act as a board
that can lightly or severely restrict the freedom of individual
owners. Presumably this is done for the benefit of the majority.
For example, in a co-op you may not be able to rent your unit,
there may be pet restrictions, and when you sell your shares the
sale will be subject to board approval of the buyer.

Manufactured housing - Also known as mobile homes, double-wides,
etc., manufactured housing is treated by the marketplace more
like a car than it is like a house. Mobile homes depreciate in
value over time like cars do (rather than appreciating like a
house), so you generally obtain a standard loan (like a car loan)
rather than a mortgage. Manufactured housing is not the subject
of this article.

You can choose to live in any type of housing, although in general
the topics addressed in this article focus on the purchase of
a house.

Step 4: Talk to a Realtor and start looking at houses

There are two ways for you to search for a house. You can either
look in the paper or in magazines advertising houses for sale
by owner and you can purchase a house directly from the owner.
This route has the potential to be less expensive, because an
owner who sells his or her house does not have to pay a 7% Realtor
commission. The disadvantage of this approach is the fact that
it can be harder to find a home that you like because of a more
limited selection, the difficulty in scheduling visits to each
home.

The more common way to search for a house is to use a Realtor.
Realtors have the following advanages:

Use whichever technique feels more comfortable. If you use a Realtor,
take time to shop around and find someone whose style and market
niche matches your own. One good way to do this is to seek recommendations
from friends at work. Since you have a choice, choose a Realtor
with extensive experience, and do not allow the Realtor to rush
you.

Step 5: Find a house that you like

After searching for a period of time you will presumably find
a house that you like in a reasonable location with a price that
you can afford. It may take several months of searching to find
such a house. At the moment you find it, make an offer immediately.
It is not uncommon for a good house at a good price to be purchased
by someone else if you hesitate for too long. This is the most
common way to lose a house that you really like.

There is a funny thing that happens to many people right after they
make the offer. It is commonly known as buyer's remorse. It
is the feeling that you have just done something extremely stupid, and often occurs
right after you sign your name and hand over the deposit check.
Buyer's remorse is a natural human emotion. You can combat it to
some extent by making up a written list of advantages and disadvantages
for the house as part of your decision-making process. If this list is
sound and true, then when buyer's remorse kicks in you can refer to the list
and reassure yourself that you did the right thing. Or maybe not.
Just be aware that the phenomena is common and be prepared for it.

Step 6: Make an offer on the house

You make an offer to purchase a home by signing an offer to
purchase form and writing a check. The check acts as a deposit
and represents your commitment to following through with the purchase
should the offer be accepted. This money is normally referred
to as earnest money. The check will be cashed, and the
money will be placed in escrow. An escrow account is simply
a bank account managed by a neutral third party, generally the
Realtor or a lawyer. Should you be unable to follow through on
your commitment to purchase, you will lose your earnest money.
Should the offer not be accepted, the money will be returned to
you. The amount of earnest money you will be asked to give varies,
but generally is 1% of the purchase price. This money is applied
to the purchase price at the closing if the deal is successful.

A standard offer to purchase is a single sheet of paper. On one
side are a number of blanks where you fill in your name and address,
the offer price, the amount of earnest money, and any conditions
or contingencies on the offer. On the back are a number of standard
condition paragraphs. For example, many localities require a termite
inspection or bond on any house that is sold. There will be a
standard paragraph covering this condition. Should the house fail
to pass a termite inspection the offer will be nullified and your
earnest money will be returned to you.

You can also add your own condition and contingencies. One common
condition added by most sellers is "subject to loan approval."
That way, if you are denied a mortgage you get your earnest money
back. Another common condition is "subject to a satisfactory
home inspection by a licensed inspector." You, as the buyer,
will have to pay for the inspection ($100 to $500), but you can
use the results of the inspection to request repairs to the house
prior to purchase. The seller pays for these repairs. You can
stipulate that the seller will pay certain closing costs (this
is important because it can save you a lot of money - see step
12). You can, in fact, add any conditions that you like (contingent
upon sale of an existing home, contingent upon repair of the roof,
contingent up removal of dead trees in the yard, etc.), but at
the same time the seller has the option of rejecting them.

The most important part of the offer to purchase is the offer
price. The seller places the house on the market with an asking
price. You have the option to offer the asking price, or more,
or less. If you know that you have three competitors and you really
love the house, you may have an incentive to offer more than the
asking price, but generally you will offer less. The amount that
you offer depends on your personality and your negotiating strategy.

Step 7: Negotiate a price

The seller will either accept your offer, reject it, or make a
counter offer. If you receive a counter offer you have the right
to accept it or make a counter counter offer. At this point you
negotiate with the seller until you reach a price and terms that
are agreeable to both parties. If you do not reach agreement,
the offer is eventually rejected, your earnest money is returned
to you, and you get to start over again. This is the second way
that you can lose a house that you like.

Step 8: Shop for and select a mortgage company

There are a number of good reasons to talk to a mortgage company
prior to searching for a home (see Step 2). If you do not then
at this point you must start the process. Search for a company
that has good rates and that seems to understand you and your
financial situation. Ask several different banks or mortgage companies
for quotes - the rate differences can be amazing. You local paper
will often publish a list of banks with the lowest rates in the
area.

Step 9: Apply for a mortgage

There are two different types of mortgages: fixed-rate and adjustable-rate
(also known as ARMs). Fixed rate mortgages come in 15-year and
30-year formats. Adjustable rate mortgages come in many different
forms, but the most common form starts at some rate and then adjusts
itself every six months or year depending on changes to the prime
rate.

Adjustable rate mortgages generally start with a interest lower
rate, but carry the sometimes-significant risk that your monthly
payment will rise if interest rates rise. Fixed rate mortgages
are guaranteed to maintain the same monthly payment over the life
of the loan.

Once you have chosen a mortgage company and a mortgage type, apply
for the loan by filling out the appropriate paperwork and supplying
all of the requested information.

Step 10: Wait for approval on the mortgage

Approval may take several days or weeks, depending on the mortgage
company. You may be asked to supply additional information during
the process.

As discussed in Step 2, much of the nail-biting than accompanies
the mortgage-approval process can be eliminated by getting your
mortgage pre-approved. See Step 2 for more information and talk
to your mortgage company before starting your search for a house..

Step 11: Wait for the closing

At the time your offer is accepted by the seller, you and the
seller will negotiate a closing date. With the mortgage approved
all that you can do is wait for the closing date, prepare to move,
and hope that nothing goes wrong.

Step 12: Attend the closing and sign all of the paperwork

Finally the closing day arrives. This should be a day of rejoicing
because on this day you will become the proud owner of a new home.
Unfortunately this day is instead one of frustration and myriad
small details unravel. It is not exactly clear why this unraveling
is so common, but it is definitely the case.

The closing normally occurs at the office of a lawyer. At the
closing you will be required to pay quite a few fees, so bring
your check book and make sure you have plenty of money in your
account (the lawyer will normally provide you with a total closing
cost prior to closing day, but be sure to have at least $1,000
over and above that cost available just in case).

The costs that you may be expected to pay at the closing may include
the following, depending on how closing cost payments are negotiated
when you make your offer to the seller:

Loan origination and/or processing fees

Points on the loan (points are a front-end interest charge
assessed by the lender. The more points you pay, the lower your
monthly payment because you are paying your interest early. Each
point represents 1% of the mortgage's value. It is not
unusual for a lender to require you to pay two to three points
at closing, and it is preferable for tax reasons to pay them yourself
with a check rather than wrapping them into the mortgage.)

Up to one month's worth of mortgage payment, depending on
the closing date

The amount of the down payment (perhaps 10% of the home's
purchase price)

Lawyer fees

City and county Taxes

Homeowners fees (for town houses, condos, etc.)

Title search and title insurance fees

Surveying fees

Deed registration or filing fees

Homeowners insurance fees (paid either prior to or at closing)

And so on

The total figure can add up to thousands of dollars. Some banks
will let you roll these fees into the mortgage, but many will
not and in that case you will have to have the cash available.
You will also sign at least 15 pieces of paper.

Step 13: Move in to your new home

Presumably this part is easy, and once you have moved in you can
sit down on your couch and you can congratulate yourself. After
several months or years of hard work you have successfully bought
your part of the American Dream!